Market failure is a situation in which the allocation of goods and services is not efficient.

1. MARKET FAILURE
DR. ARIFA SAEED

2. DEFINITION
 Market failure is a situation in which the allocation of
goods and services is not efficient.
 In this situation market forces of demand and supply fail to
allocate resources efficiently.
 This happens when production or consumption of a good /
service causes effects on third parties as well. These third
parties are not involved in the production or consumption.

3. THIS MIGHT BE CAUSED DUE TO THE FOLLOWING REASONS:
Reasons Description
1. Demerit goods over
consumed
Goods such as demerit goods that have external costs are over-consumed.
This is because without government intervention they would be cheap and
consumers won’t understand their harmful effects leading to over consumption.
Example: Tobacco or alcohol.
2. Merit goods under
consumed
Goods such a merit goods that have external benefits are under-consumed.
This is because without government intervention they would be expensive and
consumers won’t understand their benefits so they would be under-consumed
Example: Education or health care
3. Presence of Monopolies A monopoly is single dominant firm in the market that restricts output, pushing
up prices and reducing the amount people can consume.
4. No public goods Private sector firms have no incentive to provide public goods so these won’t be
consumed. Example Street lighting, lighthouses, national defense, flood control
systems etc.

4. PRIVATE, EXTERNALAND SOCIAL COSTS
 1. Private Costs: These are costs that are incurred by those who buy products and those who produce
products. Example: A person buys a bottle of coke for $10, a firm purchases machinery for $15000 these are
all private costs.
 2. External Costs: These are costs or negative side effects imposed on the third party because of the
economic activity of others. Example: An individual becomes drunk and cause public nuisance, a firm
production cars in a factory might cause air and noise pollution to the nearby areas.
 3. Social Costs: These are total costs to the society of an economic activity. It is the total cost that both
consumers and producers go through.
 Private Cost + External Costs = Social Costs


5. 3. PRIVATE, EXTERNAL AND SOCIAL BENEFITS
 1. Private Benefits
 These are internal benefits of production and consumption received by those who produce or consume the products.
Example: A car owner gains the benefits of driving the car, a firm gains revenue by selling off old machinery.
 2. External Benefits: These are benefits to the third party from consumption or production of others. Example: If an
individual maintains a garden the neighbors can benefit from fresh air, firms of cars opens in an area can provide
employment.
 3. Social Benefits: These are total benefits to the society of an economic activity. It is the total benefit that both
consumers and producers consume. Example: If an individual gets vaccinated he receives a private benefit that he won’t
get a disease and will generate an external benefit that people will also be protected from a contagious disease.
 Private Benefit + External Benefits = Social Benefits

6. 4. GOVERNMENT INTERVENTION – REDUCE
SOCIAL COSTS
 Intervention 1 – Improve Indirect Taxes (Reduces
Supply)
 Government try to solve market failure by imposing
indirect taxes on prices of demerit goods like alcohol,
cigarettes etc. Taxes are compulsory transfer of
money from private sector to the government. By
imposing an indirect tax the price of cigarettes the
supply will decrease. Indirect tax is a tax that is added
to the price of the product. Since the goods becomes
expensive to produce the suppliers would be reluctant
to provide it since it marks low profitability. The
impact can be shown with the help of a diagram.

7. Advantages Disadvantages
1. The tax increases the price of
the product which results in a
decrease in quantity.
2. It generates revenue for the
government which can be used to
provide merit goods for the
masses like education and health
care.
1. It won’t be highly effective in
reducing the demand for products
that have an inelastic demand.
2. The burden of the tax will fall
more on poor people rather than
rich individuals which generates
inequality.

8.  Intervention 2 – Impose Rules and
Regulations (Reduces Demand
 Governments can also impose rules and
regulations in an attempt to solve market
failure. These laws can include imposing
age restriction like smoking is only
allowed for individuals above the age of
18 to passing laws that restrict
consumption like banning smoking in
public, airports etc. This will reduce the
consumption by decreasing the demand.
The impact can be shown with the help
of a diagram

9. Advantages Disadvantages
1. This reduces the consumption of demerit
goods.
2. The behavior of the individuals might be
modified in the long run. Example: If the
law is that you can’t drink and drive, over a
period of time it can reduce the overall
consumption by an individual.
1. Restriction causes formation of black markets
where goods are sold illegally and at a high
price.
2. Individuals might by pass the law by making
false identification cards.
3. If the fine or punishment is not high enough
the laws won’t be effective.

10.  Intervention 3 – Education and Advertisement
(Reduces Demand)
 Governments can also use schools and advertisements
to motivate people not to smoke. Government can
launch campaigns against smoking in schools and on
television to discourage the habits. When children
would be educated they are less likely to carry on the
habit in the future. The impact can be shown with the
help of a diagram:

11. Advantages Disadvantages
1. Since the individual known the dangers of
smoking they are less likely to consume the
product.
2. Successful advertisements might lead a
cultural change in the long term. Individuals
might train their next generation to avoid
demerit goods.
1. The money spend on educating and
advertisements could have been spent on other
merit goods.
2. Not all advertisements are equally effective.
3. It takes time for people to change habits and
in the meantime the consumption of demerit
goods is continued.

12.  Intervention 4 – Minimum Pricing:
 Definition / Minimum Price: A legally set
minimum price is called a price floor. It means
that the seller cannot charge a price lower than
the minimum price. This is used to set a price
higher than the equilibrium price do discourage
demand for a demerit good. Examples: Imposing
a minimum price for demerit goods like tobacco
products and alcohol.

13. 5. GOVERNMENT INTERVENTION – PROMOTE SOCIAL
BENEFITS
 Intervention 1 – Subsidies (Increases Supply)
 The government often uses subsidies to promote the
production and consumption of goods that have social
benefits. A subsidy is a grant given by the Govt. to
the firm to increase the production of a good and
reduce the market price so that consumers can
easily buy the good. Example: The govt. might
subsidize the production of electric cars in a country to
encourage the consumption instead of traditional petrol
cars. Since electric cars would be cheaper to produce,
more manufacturers would be willingly to produce it.
This would increase use of electric cars would reduce
air and noise pollution hence increasing social benefits

14. Advantages Disadvantages
1. Enables greater social efficiency.
Consumers end up paying the socially
efficient price which includes the external
benefit.
2. Subsidies can also help reduce social
costs as by encouraging electric cars,
demand for petrol cars would go down,
reducing pollution.
3. . In the long term, subsidies for a good
will help change preferences. It will
encourage firms to develop more
products with social benefits.
1. There is a danger that government subsidies
may encourage firms to be inefficient and they
come to rely on subsidy rather than improve
efficiency.
2. A subsidy involves opportunity cost and
the money can be used somewhere else
that reduces market failure even more.
Like Healthcare.
3. Firms may not pass the benefit of the
subsidy restricting the demand to rise.
4. It is difficult to estimate the extent of the
eternal benefit; therefore, the government may
have poor information about the service and
how much to subsidize.

15.  Intervention 2 – Education and Advertisement
(Increase Demand)
 The government can also informative advertisement
and education to explain to the masses the benefits of
consuming consumption products that are good for
them. Example: The government might launch
campaigns in schools and on several media platforms
encouraging masses to consume fresh fruits and
vegetables. This would increase the demand and
create healthier economy where fewer individuals
would use healthier services, producing an external
benefit to the society. The impact can be shown with
the help of a diagram:

16. Advantages Disadvantages
1. Since the individuals known the
benefits of vegetables they are more
likely to consume the product.
2. Successful advertisements might
lead a cultural change in the long
term. Individuals might train their
next generation to consume more
fruits and vegetables.
1. The money spend on educating and
advertisements could have been spent
on other merit goods.
2. Not all advertisements are equally
effective.
3. it takes time for people to change
habits.

17.  Intervention 3 – Maximum Price
 Definition / Maximum Price: A government may in
some situation set a legal maximum price for a
particular good; this is called a price ceiling. It means
that the seller cannot charge a price higher than the
maximum price. This usually happens for necessities
where the government wants necessities or certain
commodities to be more affordable for to the low-
income earns. Examples: Rent controls and Food price
controls.